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I am about to share the worst trade of my carrier with you. It cost me a fair amount of sleep (and probably cost me a number of subscribers, who must have thought Simon is quite the moron).

Here is the sad tale of a good trade hijacked by an ETF flaw (fortunately there’s a happy ending).

The Setup

Earlier this year, in mid-January, we saw a number of VIX extremes, such as highly elevated SKEW readings (SKEW measures ‘black swan’ risk), near-record SKEW/VIX ratio readings and the highest ever long exposure of commercial VIX traders (smart money). The charts below, published by the Proift Radar Report in January, illustrate the extremes.

Statistically, those conditions led to an average VIX spike of 22% over the next month every time (even a week later the VIX was higher 85% of the time).

The biggest problem (which we were well aware of) was the lack of a suitable trading vehicle for long VIX exposure. Yes, there is VXX, but it suffers from contango (we have often successfully shorted the VIX via XIV, which puts contango in our favor, more about XIV below).

What is Contango?

Below is a brief explanation of contango (taken from an August 2014 report):

The VIX quoted in-day-to-day life is the CBOE Volatility Index (VIX) spot price (today’s VIX price). However, the futures used to create ETPs like the iPath S&P 500 Short-Term VIX Futures ETN (VXX) are based on the future VIX price, which is almost always more expensive than the spot price. Over time the more expensive VIX futures decline in value, eventually converging with the spot price at expiration.

The chart below compares the current spot price with various futures prices. The difference between the spot price (12.20) and the September futures (13.45) is 9.84%. In other words, it will take a 9.84% move in the VIX to neutralize the time decay between the spot and September futures price.

As time goes by, ETF providers are forced to continuously replace expiring futures with new (more expensive) futures (this process is called ‘rolling over’). The further away the futures expiration date, the bigger the time premium. This time premium and resulting value decay is called contango.

On January 23, we pulled the trigger and bought a very small amount of VXX at 20.60. A week later, the VIX traded higher, and a month later, the VIX traded higher. The VIX even spiked 22% (as expected) a number of times, but VXX contango persistently eroded VXX.

VXX by-passed the short-term VIX spike, and then, as anticipated, the stock market continued higher (which kept the VIX depressed). Nevertheless, we expected a period of choppy trading (volatility) to start in February/March.

On March 1, the S&P 500 topped, and has basically been range bound since.

On March 23, it was obvious that the VIX would fall again before the next window for a S&P 500 correction arrived. We bought XIV to hedge VXX, which turned out to be a great move.

The Next Window

The window to unwind this unfortunate VIX trade finally arrived this week. The May 14 Profit Radar Report stated that: “We are still looking to sell XIV and double up on VXX at S&P 2,407. Aggressive traders may elect to short the S&P around 2,410.”

Unfortunately there was another blow. The S&P 500 missed our trigger level for XIV and VXX (2,407) by one point (on Tuesday, March 16). The S&P gapped lower the next morning (by 17 points), robbing us of the best opportunity to unwind this trade.

We took the second-best opportunity. The March 17 intraday Profit Radar Report recommended to sell XIV at 77.40, and double up on VXX at 14.45. We closed XIV for a profit of 12.17% and bought VXX at 14.45.

The next morning (Thursday, March 18) we closed our entire VXX trade at 15.97. The VXX portion bought on January 23 accrued a 22.47% loss, the VXX portion bought on May 17 ended with a 10.51% gain. The 11.96% loss was offset by the 12.17% XIV gain.

At the end, we closed this unfortunate trade combo with a tiny 0.21% gain.

Lessons Learned

Patience and impeccable timing (at the end) rescued this trade, but in hindsight, the best worst trade is one not taken.

Contango needs to be respected. In the past, we traded XIV six times (XIV benefits from contango). All six XIV trades were profitable (12.17%, 14.46%, 13.33%, 7.57%, 15.70%, 4.49%). It’s better to focus on XIV (falling VIX) than VXX (rising VIX), especially in a bull market.

Although we knew that the VIX would fall mid-term, we bet on a short-term rise. It’s not smart to bet against the larger trend.

With the VXX trade closed at a miniscule profit, we keep our streak of no losing trade (since June 2015) alive.

Simon Maierhofer is the founder of iSPYETF and the publisher of the Profit Radar Report. Barron’s rated iSPYETF as a “trader with a good track record” (click here for Barron’s profile of the Profit Radar Report). The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013, 17.59% in 2014, and 24.52% in 2015.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Since 1970, the S&P 500 has seen a ‘Santa Claus Rally’ (SCR) 73.9% of the time (SCR equals last five days of old year and first 2 days of new year).

Purely based on seasonality, there’s a good chance the S&P 500 will move higher in the coming days.

Due to the fairly predictable inverse correlation between the S&P 500 and the VIX, one would expect the VIX to move lower during the SCR period of the year.

However, that’s not the case. In fact, this is the biggest VIX anomaly of the year and is relected in VIX seasonality.

The December 27, 2015 Profit Radar Report observed this anomaly and stated:

“On Thursday the VIX painted a potential reversal candle, which – combined with seasonality – will probably make it harder for the VIX to move much lower. Usually the mix moves in the opposite direction of stocks, however this inverse relationship tends to take a break from Christmas to New Years.”

Simon Maierhofer is the founder of iSPYETF and the publisher of the Profit Radar Report. Barron’s rated iSPYETF as a “trader with a good track record” (click here for Barron’s profile of the Profit Radar Report). The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013, 17.59% in 2014, and 24.52% in 2015.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Since late July, our first buy trigger has been waiting at S&P 2,140 (=SPY 214.20). Months of patience (and not chasing the up side) paid off on September 9 when the S&P 500 dropped below 2,140.

Since buying SPY on September 9, we also bought the iShares Russell 2000 ETF (IWM) and the VelocityShares Daily Inverse VIX ETN (XIV). This article explains why shorting the VIX via XIV is such an attractive trade: The Spectacular VIX Tailwind Trade

We started to leg into various long positions because the weight of evidences suggests higher prices for the remainder of 2016.

However, although the S&P (and Russell 2000) reached our first down side target, the performance since hasn’t been too confidence inspiring. It is missing the escape velocity we saw in February and June.

There was also a breadth thrust right after the Brexit low in June. This kickoff rally along with two longer-term projections was detailed here: Stock Market Melt-Up Alert?

In the spirit of risk management (a bird in the hand is better than two in the bush), we trimmed our positions in XIV and IWM and cashed in some profits. Although today’s spike looks good, 2-day RSI is reaching overbought, and seasonality tends to be weak this time of year.

For now, we are happy to have bought SPY, IWM and XIV near the September lows. When stocks are up, it’s better to be long and worry about a possible relapse than being in cash (or worse short) and worry about having missed the bottom. We can now play with ‘house money.’

Continued S&P 500 updates are available via the Profit Radar Report.

Simon Maierhofer is the founder of iSPYETF and the publisher of the Profit Radar Report. Barron’s rated iSPYETF as a “trader with a good track record” (click here for Barron’s profile of the Profit Radar Report). The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013, 17.59% in 2014, and 24.52% in 2015.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

The CBOE Volatility Index (VIX) is a popular index, but in itself is not investable. You can’t just go out and buy the VIX. The same is true for the S&P 500 or any other index.

But investment vehicles like the SPDR S&P 500 ETF, which aims to replicate the performance of the S&P 500 index, make it possible to invest in indexes.

Duplicating the performance of the S&P 500, however, is much easier than creating a vehicle that mimics the VIX. Fund managers simply purchase the stocks that make up the S&P 500 to create an S&P 500-like product.

It doesn’t work like this for the VIX. Here’s why:

There is no ‘VIX stock.’ The only way to invest in the VIX is via futures or options, which are complex financial instruments. ETFs, ETNs or other ETP’s use futures or options to attain ‘VIX-like’ performance. VIX futures and options generally suffer from some sort of time decay.

Explained: Contango

The VIX quoted in-day-to-day life is the CBOE Volatility Index (VIX) spot price (today’s VIX price). However, the futures used to create ETPs like the iPath S&P 500 VIX Short-Term Futures ETN (VXX) are based on the future VIX price, which is almost always more expensive than the spot price. Over time the more expensive VIX futures decline in value, eventually converging with the spot price at expiration.

Figure 1 compares the current spot price with various futures prices. The difference between the spot price (12.20) and the September futures (13.45) is 9.84%. In other words, it will take a 9.84% move in the VIX to neutralize the time decay between the spot and September futures price.

As time goes by, ETF providers are forced to continuously replace expiring futures with new (more expensive) futures (this process is called ‘rolling over’). The further away the futures expiration date, the bigger the time premium. This time premium and resulting value decay is called contango.

Contango generally exists when the VIX is flat or trending lower. Even gradual increases when the VIX is below 20 tend to occur in an environment of contango.

Backwardation (figure 2) is the opposite of contango. Backwardation generally appears only during times of panic and significant VIX spikes above 20.

To sum up, contango erodes investors’ returns during periods of a flat or falling VIX.

How to Profit from Contango

We don’t expect a major stock market top yet, therefore the period of low volatility is likely to continue (or resume after the seasonal October VIX high).

Is it possible to use contango in our favor?

Figure 3 plots the VIX against the VelocityShares Daily Inverse VIX Short-Term ETN (XIV), and reveals a very simple truth: XIV has risen much more than the VIX has fallen.

Figure 4 shows the cumulative gain/loss from January 3, 2011 to August 15, 2014. The VIX lost 25%. XIV gained 242%. XIV returned 217% more than the inverse VIX.

XIV’s objective (and the objective of every other inverse or leveraged ETP) is to replicate the daily (not long-term) inverse performance of the VIX, but regardless, this kind of excess return is worth exploring.

Here is a more detailed breakdown of XIV’s excess return.

XIV is an inverse VIX ETN. For an apples to apples comparison, we are comparing XIV with a simple inverse VIX.

Of the 911 trading days from January 3, 2011 to August 15, 2014, the inverse VIX had 484 up days and 427 down days. The inverse VIX had 1.13x more up than down days.

The average gain of 484 up days was 4.55%. The average loss of 427 down days was 5.85%. The average loss was 1.28x greater than the average gain.

Of the 911 trading days from January 3, 2011 to August 15, 2014, XIV had 522 up days and 389 down days. XIV had 1.34x more up than down days.

The average gain of 522 up days was 2.63%. The average loss of 389 down days was 3.18%. The average loss was 1.21x greater than the average gain (see figures 5 and 6).

Summary

Since 2011, XIV outperformed the inverse VIX by 217% (0.24% per day). Although there are other factors at work, the excess return of 0.24% per day is largely attributed to the effect of contango.

Contango does not guarantee a profitable trade or protect against losses. From July 7 – November 21, 2011 XIV lost 75%. There are also times where the VIX moves lower and XIV loses value (i.e. August 18 – 21, 2014).

Over time however, contango significantly enhances the odds of a successful XIV trade, especially when XIV is purchased during times of VIX spikes.

A list of VIX Exchange Traded Products that benefit from contango, a updated VIX seasonality chart, and actual buy/sell signals are available via the Profit Radar Report.

Simon Maierhofer is the founder of iSPYETF and the publisher of the Profit Radar Report. Barron’s rated iSPYETF as a “trader with a good track record” (click here for Barron’s profile of the Profit Radar Report). The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013, 17.59% in 2014, and 24.52% in 2015.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

The VIX gained 41% on June 10 and June 13, while the S&P only lost 1.72%.

On June 7, 8, 9, the VIX moved higher along with the S&P 500.

What does this mean?

While the scope of the VIX spike is unprecedented, a higher VIX was to be expected.

The June 8 Profit Radar Report (S&P 500 closed at 2,119 that day) published the chart below along with the following warning:

“Volatility, as measured by the average true range (ATR), has dropped to the lowest level since June 29, 2015. The chart shows that low ATR, a sign of complacency, tends to be negative for stocks. We will go short the S&P 500 if it drops below 2,110.”

The next day, the S&P started falling and the VIX starting soaring. On Friday June 10, the VIX spiked 16.33% despite a subdued S&P 500 loss of only 0.92%.

The VIX Spike in Historical Context

What does this discrepancy between VIX and S&P mean? The June 12 Profit Radar Report featured the following analysis:

“Despite a somewhat subdued S&P loss of ‘only’ 0.92%, the VIX spiked 16.33%. This appears excessive, but those kneejerk reactions have almost become the norm as the bull market nears maturity and investors are afraid every decline is the ‘big one.’

The chart (updated chart shown below) plots the S&P 500 against the VIX. The lower panel shows S&P 500 losses and corresponding VIX gains. The dotted red boxes highlight various declines since the beginning of 2014.

The numbers above the red boxes reflect the ratio between VIX gains and S&P losses (i.e. Friday: VIX of 16.33 divided by S&P gain of 0.92 = 17.79) recorded during the first few days of the decline.

Based on this comparison, Friday’s VIX spike, although a potential over reaction, is not necessarily above the norm.”

On the next day (June 13), the VIX spiked 23.14% despite another tame S&P loss of only 0.81%. As the updated chart shows, the ratio of 28.51 has become very unusual.

History suggests that the VIX is due for a mean reversion move (lower). XIV is usually a good vehicle for this mean reversion trade, but it is worth noting that contango tends to turn into backwardation when the VIX sustains trade above 20.

The Profit Radar Report kept it simple and recommended to short the S&P 500 at 2,110.

Simon Maierhofer is the founder of iSPYETF and the publisher of the Profit Radar Report. Barron’s rated iSPYETF as a “trader with a good track record” (click here for Barron’s profile of the Profit Radar Report). The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013, 17.59% in 2014, and 24.52% in 2015.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

More than any other asset class, the Volatility Index (VIX) is subject to distinct patterns or biases that either help or hurt investors.

Being aware of the 3 VIX tricks discussed below will significantly increase the odds of a winning trade.

1) VIX Seasonality

I invite you to inspect the VIX seasonality chart below. Based on 25 years of trading history, there are two important seasonal turning points: July 2 and October 9.

The VIX has a strong tendency to move higher starting in early July (green arrow), and to move lower after early October (red arrow).

For example, the June 23, 2015 Profit Radar Report stated that: “The VIX closed below the lower Bollinger Band for the first time since June 6, 2014. A close back above the lower Bollinger Band will be a buy signal. VIX seasonality is soon turning higher for the best VIX seasonal signal of the year.”

Shortly thereafter the VIX rallied from 12 to 20 and eventually to 50.

Due to the massive summer spike, this year’s October sell signal was shifted.

Nevertheless, the November spike (last chart, red arrow) offered a good setup to short the VIX, as the November 16 Profit Radar Report brought out: “The VIX closed below the upper Bollinger Band, which is a sell signal.”

The October sell signal is particularly intriguing because it gets magnified by a major bias of inverse VIX ETPs (Exchange Traded Products, such as ETFs and ETNs). This bias can be worth 0.25% per day for weeks.

The performance of futures-based ETPs is typically cannibalized by a condition called contango. However, a bet on lower VIX prices allows investors to turn this generally harmful condition into a superbly beneficial tail wind.

Below is an admittedly dry explanation of contango, but I think you will find it well worth your time (no pain, no gain).

The VIX quoted in-day-to-day life is the CBOE Volatility Index (VIX) spot price (today’s VIX price). However, the futures used to create VIX ETPs are based on the future VIX price, which is almost always more expensive than the spot price. Over time the more expensive VIX futures decline in value, eventually converging with the spot price at expiration.

As time goes by, ETF providers are forced to continuously replace expiring futures with new (more expensive) futures (this process is called ‘rolling over’). The further away the futures expiration date, the bigger the time premium. This time premium and resulting value decay is called contango.

Contango generally exists when the VIX is trading below 20. The opposite of contango – backwardation, when future VIX prices are lower than at present – generally appears when the VIX trades above 20.

I wrote a detailed report on how to actually make contango work for investors back on August 24, 2014 (entire report available to subscribers of the Profit Radar Report).

Below are some of the findings and charts shared in this report:

The two biggest beneficiaries of the ‘reverse contango’ benefit are the VelocityShares Daily Short-term VIX ETN (NYSEArca: XIV) and ProShares Short VIX Futures ETF (NYSEArca: SVXY).

The chart below compares the VIX with its inverse counter part, XIV. Shown is the cumulative percentage return from January 3, 2011 to August 15, 2014.

It quickly becomes obvious that XIV has risen much more than the VIX has fallen.

XIV is an inverse VIX ETN. For an apples to apples analysis of the excess return, here is a comparison between XIV and an inverse VIX (the VIX inversed).

Of the 911 trading days from January 3, 2011 to August 15, 2014, the inverse VIX had 484 up days and 427 down days. The inverse VIX had 1.13x more up than down days.

The average gain of 484 up days was 4.55%. The average loss of 427 down days was 5.85%. The average loss was 1.28x greater than the average gain.

Of the 911 trading days from January 3, 2011 to August 15, 2014, XIV had 522 up days and 389 down days. XIV had 1.34x more up than down days.

The average gain of 522 up days was 2.63%. The average loss of 389 down days was 3.18%. The average loss was 1.21x greater than the average gain (see figures 5 and 6).

From January 3, 2011 to August 15, 2014, XIV outperformed the inverse VIX by 217% (0.24% per day).

Obviously the reverse contango benefit doesn’t guarantee a profitable trade, but on average XIV provides a ‘daily edge’ of 0.25%. At times, the edge is much more pronounced, such as on November 30, 2015, when the VIX rose 6.68%, but XIV gained 0.74% (when it should have lost some 6.68%).

VIX Technical Analysis

As you may have noticed from the two above Profit Radar Report quotes, the Bollinger Bands can be very helpful when it comes to spotting buy/sell signals, especially when they occur near the two major seasonal turning points (see chart below).

Simple support/resistance levels and trend channels can also be of help. The green/red arrows below highlight the buy/sell signal given by the Profit Radar Report.

Summary

Seasonality and technical analysis triggered a VIX sell signal on November 16.

The sell signal remains active and the ‘contango tailwind’ should by overall positive for XIV until late December.

However, for the first time since the start of the 2009 bull market, we are seeing signs of distribution (liquidity is drying up). This could become an issue when the next (bullish) VIX turning point arrives.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013 and 17.59% in 2014.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

On August 24, the VIX briefly soared to 53.29, I was getting ready to leave for Europe that day, but saw the action on my phone and thought: “Boy, wish I had the time to figure out a good VIX short.”

I even wrote in the August 24 Profit Radar Report update that: “Today’s VIX high (53.29) will likely stand for a while. Buying XIV (inverse VIX ETN) is tempting, but the issue with XIV is that we may not have the benefit of contango right now, but the drag of backwardation.”

An explanation of contango and backwardation (along with the best seasonal VIX signal) is available here (last two paragraphs).

In short, backwardation is a condition that either increases XIV or SVXY losses or erodes XIV and SVXY gains while the VIX trades above 20 – 25.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013 and 17.59% in 2014.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.